2-1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-2 CORPORATE FORMATIONS & CAPITAL STRUCTURE (1 of 2)  Organization forms available  Check-the-box regulations  Legal requirements for forming a corporation  Tax considerations in forming a corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-3 CORPORATE FORMATIONS & CAPITAL STRUCTURE (2 of 2)  §351: Deferring gain or loss upon incorporations  Choice of capital structure  Worthless stock or debt obligations  Tax planning considerations  Compliance & procedural considerations  Financial statement implications Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-4 Organization Forms Available  Sole proprietorships  Partnerships  Corporations  C Corporations  S Corporations  Limited liability companies  Limited liability partnerships Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-5 Sole Proprietorship Basic Concepts  One owner  Not a separate legal entity  Income reported on Sch. C of 1040  No limited liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-6 Sole Proprietorship Tax Advantages  Profits taxed once  Proprietor’s marginal tax rate may be lower than if business were taxed as a corporation  No tax on contributions or withdrawals  Losses offset other income w/limits Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-7 Sole Proprietorship Tax Disadvantages  Profits taxed as earned, not as received  Corporate tax rates may be lower than proprietor’s marginal tax rate  Owner not employee  Profits subject to SE tax  Not all tax-exempt fringe benefits available  Compensation to owner not deductible  No fiscal year deferral Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-8 Partnerships Basic Concepts  Two or more owners  Conduit entity  Reports, but does not pay income tax  No limited liability  Except for limited partners Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-9 Partnerships Tax Advantages  No partnership-level taxes  Income only taxed at partner level  Losses offset other income w/ limits  Contributions and withdrawals generally not subject to taxation  Income retains its character  Income/gain increases basis Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-10 Partnerships Tax Disadvantages  Profits taxed as earned, not received  Partners, not employees  Profits subject to SE tax  Not all tax-exempt fringe benefits available  Cannot use fiscal year-end to defer income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-11 C Corporations Basic Concepts  Separate taxpaying and legal entity  Limited liability  Corporate level tax  Rates 15% - 35%  Dividend distributions taxed to owners at lower capital gains tax rates Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-12 C Corporations Tax Advantages  Corp’s marginal tax rate may be lower than owners’ tax rates  Shareholders may be employees  No SE tax  Eligible for tax-exempt fringe benefits  Compensation to owners deductible  May choose fiscal year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-13 C Corporations Tax Disadvantages  Double taxation of income  Corporate and shareholder level  Taxed at lower capital gains rates (generally 15% through 2012)  Withdrawals (dividends) taxable  NOLs cannot be used in current year  Capital loss cannot offset ordinary inc Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-14 S Corporations Basic Concepts  Conduit entity  Similar to a partnership, but  Less flexible than a partnership  Must file an election to be an S Corp  Subject to rules under Subchapter S  Follows same rules as a C Corp except for specific items addressed in Subchapter S Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-15 S Corporations Tax Advantages  Generally no corporate-level tax  Losses flow through to shareholders  Income retains its character  Contributions and withdrawals generally not subject to taxation  Income/gain increases basis  Shareholders may be employees  S Corp net income not subject to SE tax Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-16 S Corporations Tax Disadvantages  Profits taxed as earned  S Corp shareholders generally not eligible for tax-exempt fringe benefits  S Corp cannot choose a fiscal year to obtain income deferral Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-17 Limited Liability Companies  Limited liability for all owners  No ownership restrictions  May be taxed as partnership or corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-18 Limited Liability Partnership  Partners liable for only their own actions  No liability for negligence or misconduct of other partners  May be taxed as either a partnership or corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-19 Check-the-Box Regulations (1 of 2)  Unincorporated entities choose to be taxed as partnership or corp  Sole proprietor or corp if one owner  Entity must choose tax status or  Accept default status  Partnership (sole proprietor if one owner) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-20 Check-the-Box Regulations (2 of 2)  Change in status results in a deemed liquidation/reincorporation  Partner deemed contributions to electing corp is nontaxable  Corp electing to be disregarded is taxable Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-21 Legal Requirements for Forming a Corporation  Dependent on state law  Minimum capital requirements  Filing articles of incorporation  Issuing stock  Paying state incorporation fees  May also be assessed franchise taxes Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-22 Tax Considerations in Forming a Corporation  Items affecting tax consequences of forming a corporation  Property to be transferred  Services to be provided  Liabilities transferred  How property should be transferred  E.g., contribution, sale  See Table 1 for overview of corporate formation rules Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-23 §351 Deferring Gain or Loss upon Incorporation (1 of 2)  No gain or loss recognized if:  PROPERTY transferred in exchange for stock and  Transferors have control (80%) of corp immediately after the exchange  Transfers may be for new or existing corporations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-24 §351 Deferring Gain or Loss upon Incorporation (2 of 2)  Property requirement  Control requirement  Stock requirement  Exchange solely for stock  Effect of §351 on transferors  Effect of §351 on transferee corp  Assumption of the transferor’s liabilities  Other considerations in a §351 exchange Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-25 Property Requirement  Property does not include:  Services  Indebtedness of transferee not evidenced by a security  Interest on indebtedness of transferee that accrued on or after beginning of transferor’s holding period for the debt Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-26 Control Requirement  Transferors must own at least:  80% of total combined voting power of all classes of stock and  80% of total number of shares of all other classes of stock  Contribution of services & property  Stock of transferor counted toward 80% if FMV of property  10% of service’s value Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-27 Effect of §351 on Transferors General Rules  No gain or loss recognized  Basis in stock same as basis in property (substituted basis)  Holding period of stock includes holding period of assets Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-28 Effect of §351 on Transferors Receipt of Boot (1 of 2)  Gain recognized lesser of gain realized or FMV of boot received  Gain recognized when liabilities transferred exceed basis in assets transferred  Basis in stock increased by gain recognized Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-29 Effect of §351 on Transferors Receipt of Boot (2 of 2)  Basis in boot property is FMV  Holding period of boot begins day after exchange Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-30 Effect of §351 on Transferors Computing Shareholder Basis Adj. basis of property transferred +Gain recognized by transferor -Money received -Liabilities assumed by transferee corp Shareholder’s basis in corp stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-31 Effect of §351 on Transferee Corp (1 of 3)  No gain or loss recognized Transferor’s adjusted basis + Gain recognized by transferee (if any) -Reduction for loss property (if applicable) Transferee corp’s basis in property Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-32 Effect of §351 on Transferee Corp (2 of 3)  Loss property limitation  When basis > FMV of prop transferred  Corp’s basis = FMV AND  Reduction in basis allocated to other assets OR  Contributing s/h reduces her basis in corp stock  Corp recognizes gain if  Appreciated property transferred to transferor in §351 exchange Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-33 Effect of §351 on Transferee Corp (3 of 3)  Depreciation recapture potential transfers to transferee corporation  Holding period includes transferor’s holding period  Holding period begins day after transfer when basis reduced to FMV Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-34 Assumption of Transferor’s Liabilities General Rule - § 357(a)  Assumption of liabilities by transferee corp not considered receipt of money  Does not trigger gain  Increases transferee’s amount realized  Decreases transferee’s basis in stock  §357(b) - No bona fide business purpose  Assumption of liabilities considered receipt of money Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-35 Assumption of Transferor’s Liabilities Liabilities in Excess of Basis - § 357(c) Total liabilities transferred to corp -Total adj basis of property transferred Gain recognized Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-36 Other §351 Exchange Considerations Depreciation  Depreciation recapture  Transferee corp inherits transferor’s depreciation recapture potential  Computing depreciation  Transferee corp must use same method and recovery period as transferor  Allocate depreciation expense for year of transfer based on # of months held Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-37 Other §351 Exchange Considerations Assignment of Income Doctrine  Transferee generally recognizes income when A/R collected and deductions when pays A/P of cash- basis transferor Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-38 Choice of Capital Structures: Debt  Interest deductible by corp  Debt repayment not taxable to s/h  Debt received in §351 is boot to s/h  Worthless debt is capital loss to s/h  Debt distributed by corp taxable to s/h Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-39 Choice of Capital Structures: Equity  Dividends not deductible by corp  S/h only pays max 15% on div received  Through 2012  Stock redemption can be taxable dividend to s/h  Stock received in §351 not boot to s/h  Worthless §1244 stk ordinary loss to s/h  Stock dist. by corp not taxable to s/h Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-40 Choice of Capital Structures: Contributions by Nonshareholders (1 of 2)  E.g., state, local, and city governments  Contributions of money and/or property to encourage a corporation to move to a particular location  Basis of property acquired by is zero Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-41 Choice of Capital Structures: Contributions by Nonshareholders (2 of 2)  Basis of property purchased w/in 12 months of cash contribution reduced by cash received  Basis of other non-cash assets reduced by remaining cash at end of 12-month period Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-42 Worthless Stock or Debt Basic Concepts  Investment evidenced by a security that becomes worthless produces a capital loss on last day of tax year  Securities include:  Stock of a corporation  Rights to subscribe for stock to be issued  Evidence of indebtedness Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-43 Worthless Stock or Debt Ordinary Loss Situations  Securities that are noncapital assets  Securities of affiliated companies  §1244 stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-44 Worthless Stock or Debt § 1244 Stock  Qualifying small business stock  Must be the original purchaser  Ordinary loss up to $50k or $100k if MFJ  Corp must have received $1M or less of property in exchange for stock Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-45 Worthless Stock or Debt Unsecured Debt Obligations  Loans from shareholders to corp  Loan not evidenced by a security  Considered nonbusiness bad debt  Treated as short-term capital loss  Loan in connection with shareholder’s trade or business  E.g., a loan to protect one’s employment  Business bad debt – ordinary loss w/o limits Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-46 Tax Planning Considerations Avoiding §351  Mandatory provision, not elective  Avoid if transferring loss property to corp  Need to also avoid §267 related party loss limitation as well  Avoid if transferring gain property and want corp to have stepped-up basis Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2-47 Compliance and Procedural Considerations  Attachment to shareholders’ individual tax returns for §351 transactions  Must include all facts pertinent to the exchange Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 2-48 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall